Squeeze Profits From Oil With Strangles

by Tyler Craig | April 17, 2013 12:12 pm

The recent commodity collapse has claimed crude oil as one of its victims. Although oil didn’t experience nearly the same bloodbath as gold and silver[1], it has fallen more than 9%, breaking multiple support levels in the process.

On the heels of the downturn, implied volatility for options on the United States Oil Fund (NYSE:USO[2]) has risen to its highest levels of the year.

While the volatility spike hurt traders with existing short volatility positions, it should be viewed as a welcome development for option sellers going forward. Prior to the recent surge, implied volatility was languishing at multiyear lows, making it difficult to find out-of-the-money options offering adequate premium to make them worth selling.

Click to Enlarge For example, last Wednesday, with USO trading at $33.80 and 37 days remaining to May expiration, the May 33 put — which sat about 80 cents out-of-the-money — was worth a mere 50 cents.

Now, because of the notable uptick in implied volatility, option premiums have inflated.

With USO trading at $31.30 and only 30 days remaining to expiration, the May 30.50 put — which resides the same distance out-of-the-money as the May 33 put last week — is worth 68 cents.

Click to Enlarge One way to put the current implied volatility level in context — aside from recognizing it’s at the highest levels of the year — is to compare it to recent historical volatility. Even taking into account last week’s volatile selloff in USO, its 10-day historical volatility has only risen to 23%. With the CBOE Oil VIX (CBOE:OVX[3]) at 29%, it’s essentially saying that USO will be even more volatile going forward, which I suspect is unlikely.

Deciding which of the numerous short volatility strategies to use depends in large part on your directional outlook for USO. While bulls favor short puts and bears favor short calls, traders with a neutral outlook could sell both calls and puts, creating a short strangle.

If you think USO is going to be more rangebound going forward and want to exploit the potentially overpriced options, you could initiate a short strangle by simultaneously selling the May 30 put and the May 32.50 call for a net credit of 98 cents.

The max reward is limited to the initial 98 cents and will be captured if USO remains between both option strikes. Because the max risk is theoretically unlimited, traders should consider exiting to minimize the loss if USO trades outside of the expiration breakeven points of $33.50 and $29.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

Endnotes:

bloodbath as gold and silver: http://investorplace.com/2013/04/gold-bugs-got-squashed-whats-next/